Capital Structure, Cost of Capital, and Voluntary Disclosures Jeremy Bertomeu,Anne Beyer, and Ronald Dye Stanford University, Northwestern University October 2009 Abstract This paper develops a model of external …nancing that jointly determines a …rm’scapital structure, its voluntary disclosure policy, and its cost of capital. We study a setting in which investors –who provide …nancing to a …rm in exchange for securities issued by the …rm –sometimes incur trading losses when they subsequently trade their securities with a superiorly informed trader. Both the …rm’s disclosure policy and the structure of the …rm’ssecurities determine the informational advantage of the superiorly informed trader which in turn determines both the size of investors’trading losses and the …rm’scost of capital. In this setting, among other things, we establish: there is a hierarchy of optimal securities that varies with the volatility of the …rm’s cash ‡ows, that an increase in the volatility of the …rm’s cash ‡ows is associated with: an increase in the amount of debt in the …rm’s capital structure; a reduction in the …rm’svoluntary disclosures; and an increase in the …rm’scost of capital. The model predicts a negative association between …rms’cost of capital and the extent of information they disclose voluntarily. This negative association does not imply, however, that more expansive voluntary disclosure causes …rms’cost of capital to decline. The paper also documents how imposing mandatory disclosure requirements can alter …rms’voluntary disclosure decisions, their capital structure choices, and their cost of capital. We appreciate the helpful comments of the participants at the CMU Accounting Mini-Conference and the Sixth Accounting Research Workshop at the University of Bern, Ilan Guttman, Paul Newman and two anonymous referees. 1 Introduction This paper develops a model that jointly explains a firm’s voluntary disclosure policy, its capital structure, and its cost of capital. While links between a firm’s disclosure policy and its cost of capital have been established in prior academic accounting research (e.g., Botosan [1997], Botosan and Plumlee [2002]), and links between a firm’s capital structure and its cost of capital separately have been identified through research in finance (e.g., in Myers and Majluf’s [1984] hierarchical model of financing), we are notaware of any existing literature in accounting or finance that endogenously connects a firm’s disclosure policy to its capital structure, and a fortiori, any literature that connects all three of these components of a firm’s financial structure. That developing a theory that jointly explains the links among these three components is important is clear. A firm’s owners do not seek to have their firm adopt a particular disclosure policy, or aparticular form of capital structure, or even take actions to affect their firm’s cost of capital, merely for their own sake. Rather, the owners care about these components of a firm’s financial structure only to the extent that the components jointly help the owners maximize the expected value of their residual claims deriving from their ownership of the firm. Even if (contrary to fact) accounting researchers were interested onlyin understanding, say, the determinants of a firm’s voluntary disclosure policy, examining firms’ voluntary disclosure policies in isolation of these other components of firms’ financial structures would not be very revealing when the firms’ owners themselves choose their firms’ disclosure policies in conjunction with the actions they take to affect their firms’ cost of capital and capital structure. It is intuitive that there should be a relationship between a firm’s capital structure and its disclosure policy: since the owners of a firm will choose the firm’s disclosure policy to maximize the market’s perceptions of the expected value of the owners’ residual claim, the form of their residual claim – equiv- alently, the form of the securities that the firm has sold to investors – will affect the owners’ objective function, and hence also affect what subsequent disclosures will maximize that objective function. A simple example that exhibits this relationship is given by a firm that has issued debt whose face value in some states of the world exceeds the value of the firm’s assets when the debt must be repaid. In those states, barring legal or regulatory imperatives, owners of a firm interested in maximizing the market’s perceptions of the expected value of their residual claims would never disclose that the value of the firm’s assets has fallen below the face value of the debt since, by doing so, the owners would reveal that their residual claims are worthless. In the model we study, there can be a gap between the expected present value of securities a firm issues to investors, and the amount that investors are willing to pay for the securities, because the investors can anticipate at the time they buy the securities that they may subsequently incur trading losses as a consequence of having to liquidate the securities on a market on which there are insiders who have information superior to that of the market maker in those securities. This gap, which is a cost that the firm bears in raising capital, is the source of the “cost of capital” in ourmodel. 2 A firm has an interest in minimizing the investors’ expected trading losses because – as inJensen and Meckling’s [1976] original theory of capital structure – the firm itself ultimately bears the cost of these losses. The firm’s manager can reduce the expected trading losses that the investors supplying the firm with capital bear by reducing the information asymmetry between the insiders and themarket maker regarding the securities’ value in either of two ways. First, since the insiders’ private information is likely to overlap with the manager’s own private information, the manager can disclose the private information he receives. Second, the manager can have the firm issue securities whose value isnot “informationally sensitive” (Sunder [2006]), i.e., whose value does not vary with the insiders’ private information. For example, were the owners to issue debt that is genuinely risk-free, then – regardless of the insiders’ private information – the insiders have no informational advantage over anyone else in assessing the debt’s value. Thus, in the model, a firm’s capital structure and its disclosure policy jointly determine the firm’s cost of capital because they jointly determine how much information asymmetry remains between the market maker and insiders, and this remaining information asymmetry in turn determines investors’ expected trading losses and hence the firm’s cost of capital. The paper develops a formula that shows how a firm’s cost of capital varies with the design ofthe security it offers to investors and its disclosure policy. The formula, which is applicable to all securities, establishes that a firm’s cost of capital depends, differentially, on a security’s upside potential (the difference between a security’s payoff if the firm’s realized cash flows assume “high” or “medium” values) and its downside risk (the difference between a security’s payoff if the firm’s realized cash flows assume “medium” or “low” values). The formula shows that the contribution of a security’s downside risk and its upside potential to the firm’s cost of capital depends on the firm’s disclosure policy. Specifically, the formula shows that the contribution of a security’s upside potential to the firm’s cost of capital decreases as the firm discloses more information, and, perhaps surprisingly, the contribution of a security’s downside risk to the firm’s cost of capital increases as the firm discloses more information.1 The paper also develops a hierarchy involving both the firm’s optimal capital structure and the firm’s optimal voluntary disclosure policy. This hierarchy is indexed by the amount of volatility in the firm’s cash flows. The paper shows that a firm with very low volatility in its cash flows prefers to raisecapital by issuing risk-free debt and adopting an ”expansive” disclosure policy.2 Then, as its cash flow volatility increases, the firm prefers to use investment-grade debt (that defaults with low probability) combined with the continued use of an expansive disclosure policy. Then, as its cash flow volatility increases still further, the firm will continue to use investment-grade debt, but it will curtail its disclosures andadopt a ”limited” disclosure policy. As its cash flows become even more volatile, the firm will switchto using “junk” debt (which defaults if anything other than the highest cash flows occur), accompanied by limited disclosure. Finally, as its cash flow volatility becomes even greater still, we demonstrate thatit is impossible to finance the firm with any form of security accompanied by any form of disclosure. 1We defer the explanation for this result to the text below where the result is presented. 2The precise meanings of an “expansive” disclosure policy, as well as the related notion of a ”limited” disclosure policy, are given formally in the text below. 3 While reminiscent of Myers and Majluf’s [1984] famous financial hierarchy (inside financing is least expensive; outside financing with debt is more expensive; outside financing with equity is most expensive), our hierarchy is distinct from Myers and Majluf’s [1984] hierarchy in two fundamental respects: first, our hierarchy combines a firm’s capital structure choice with its voluntary disclosure policy, whereas Myers and Majluf make no reference to firms’ disclosures. Second, our capital structure hierarchy is indexed to the volatility of a firm’s cash flows, whereas Myers and Majluf’s hierarchy is indexed to the relative costliness of alternative financing methods while holding cash flow volatility fixed. The paper also contains an examination of the effects of a firm precommitting to disclose certain information that it receives or, what amounts to the same thing, studying mandatory disclosure require- ments.